Asia Open FX & Gold: Currency markets remain in the US dollar risk roundabout

Gold Markets

Gold rallied for much of Friday, aided by concerns of the second wave of Covid-19 outbreak and triggered in part by the possibility of a renewed lockdown in Houston, Texas. However, gold lost its footing later in the NY session, given the gradual recovery in risk sentiment into the close.

Gold put in an intense week, despite shedding gains on Friday. Mostly there seems to be enough risk to continue to float gold, but the market remains unsure about putting in new highs this week, while if the US unemployment rate remains persistently high over the medium term, the economy will require more stimulus and gold should benefit from rising debt. 

But with all eyes trained on The Fed's Monetary Policy Report to Congress, the outcome should be very friendly to gold – especially if Chair Powell reiterates that the economy would remain prone to "persistent fragilities" as a result of the shock to economic activity arising from the Covid-19 pandemic.

Currency markets are still on the risk roundabout

Risk appetite has recovered some ground. But with Covid-19 Friday playbooks getting dusted off where, from March until very recently, the tendency was to de-risk across all assets into the weekend, the SPX was never going to fire higher without meaningful news to shift the mood on Friday.

Market shenanigans

As I wrote on Friday, even as risk sentiment was rising off the mat, I expected someone to test the downside before the day was over. And, sure enough, at midday NY we touched 2985 before recovering 60 points into the close. It brings back memories of the old days when the boss had us make calls during lunchtime on Friday to hit virtually every market maker bid simultaneously.

But it’s so much easier to move the market via electronic venues these days during Friday lunchtime liquidity, especially with everyone working from home and cross-asset desk communication completely disjointed. 

Stark reminder 

Texas serves as a reminder of the economic risks of a second wave of Covid-19. While the historic drop in the UK GDP during April is a lingering mnemonic of how damaging the first wave has been, it’s still not clear what the policy response would be to a second wave. In the US, Treasury Secretary Mnuchin said the US should not shut down even if there’s a renewed surge in infection rates, telling CNBC, "we can't shut down the economy again." 

Risk of community transmission

However, if the continued relaxation does little more than provide an open window for community transmission, short sellers will run roughshod over US equity markets. But that begs the question: why on earth would you want to own US dollars when other economies around the world are emerging from lockdown with the virus well under control so far? Sure, the market infatuation with risk-on risk-off could last a bit longer, but with the Fed staying on a dovish tack and rates on hold, you can’t expect the USD curves to remain bid.

And even if the US government doesn’t instigate a second round of lockdowns, consumer behavior will most certainly be impacted via self-imposed stay-at-home measures. Regardless of the government mandates, there could be an adverse knock-on effect across every sector as the recovery at minimum slows as people stay at home to avoid catching the flu. 

The second wave of Covid-19 remains the greatest threat to markets if you can’t get people over the line.

The Fed needed to move its narrative forward

Outside of intensifying worries around a resurgence of Covid-19, last week's collapse in risk appetite might also suggest a heightened sensitivity around the extent of policy support for asset prices. The Fed on Wednesday had sounded dovish, but the problem for markets is that the Fed didn’t move its narrative forward. 

As for forex markets, last week started with continued positive risk sentiment, equities holding onto gains, a general USD selling bias and risk premium continuing to be taken out of vol curves. However, the combination of concerns around the second wave of coronavirus and a Fed that delivered on expectations rather than exceeding them, led to corrections and paring back in currency risk overall.

There was light new participation on the US dollars upside move

Interestingly, there’s been less participation than one would expect in the risk-off moves, which suggests consolidation rather than an outright correction from here. I still think we’ll see a lot of reshuffling as risk assets will continue to trade mixed early in the week; Friday’s market zig zag proclivities and straight-up US dollar trends could be tougher to come by with Covid-19 making the headlines reels again. 

Cross trade proclivities remain in vogue

Last week, when there were initial signs that investors were starting to guard against the US dollar bear trap, it was the clear signal to play the FX crosses rather than testing the fickle nature of risk sentiment – especially ahead of the FOMC. For example, CHF-JPY to move lower, having reached stretched YTD levels. 

AUD-NZD could now stand to move lower as NZD's recent underperformance stands at odds with the economic reopening. Thinking Brexit becomes more in focus; a safer expression would be to buy EUR-GBP as Brexit risk will become a more prominent driver (see last week’s pre-FOMC set up note). 

The Swiss Franc

The Swiss Franc briefly dropped below 1.09 last week, driven by speculative investors unwinding long positions in the wake of favorable European developments. Signs of renewed interest in Europe as an investment destination for Swiss investors could trigger franc outflows, which would then drive the currency weaker.

The British Pound 

Friday, along with weekend developments, illustrates how Brexit is likely to become a critical factor for GBP going forward. 

The UK's chief Brexit negotiator, David Frost, retweeted the government's position on the on-the-transition period, stating, "we will not ask to extend it. If the EU asks, we will say no". The combination of a Covid-19 induced recession and a no-deal Brexit could provide the knockout punch, and the UK economy could struggle to lift off the mat well into 2021.

The Euro 

The resurfacing of coronavirus fears in the US-led to a sharp selloff in risk assets and EURUSD had another steep selloff in the US market. Still, given the reopening of economies in Europe and steady infection numbers, I hardly see a reason to sell the Euro, other than for positioning and the market perception that it should go lower in a risk-off environment. Whether or not that correlation makes sense at the moment is another question.

The US dollar

After surging earlier this year, the US dollar is shifting lower as the dollar was arguably well overvalued but benefited from steady inflows into US stocks while exhibiting haven tendencies. But that’s changing as investors are increasingly looking outside the US for investment. And with US dollar short-sellers less encumbered by vol-adjusted carry, which is now relatively low on most G10 crosses, it should be just a matter of picking your spots. However, the main obstacle in that view is a pickup in virus transmission as the reopening process gets underway outside the US.